The time to act is NOW.

That deer in the headlights look!

On Tuesday, September 18, 2018 the VA released new regulations applicable to the VA pension benefit, variously known as “improved pension,” “new pension,” “special monthly pension,” “housebound” or “aid and attendance.”

The regulation is set to take effect thirty days after publication. This has set up a less than 30 day count-down for those who may have been considering asset transfers or trust funding to qualify for potential VA benefits within the next three years.

The regulations provide new rules regarding how much net worth a VA benefit applicant may retain and qualify for benefits (actually some good news there) and provide new Medicaid-like transfer penalties (sanctions).

This brief memo discusses those rules applicable to needs-based VA benefits (those that impose asset and income limits). This memo does not discuss various rules regarding activities of daily living applicable to independent, assisted, or in-home living arrangements. Nor does this memo discuss any changes to service-connected benefits.

References to the new regulations under Title 38, Part 3, of the Code of Federal Regulations are shortened to “Reg. § 3.2**” format.

New Net Worth Limits

Let’s get the good news out of the way. The new net worth rules for an applicant are a relief from the old and ambiguous asset rules. Under the old rules an applicant could not have more than $80,000 in countable assets in any event, and VA caseworkers routinely lowered this limit depending upon an individual applicant’s age, health, or marital status. In fact, the VA Commentary (the “Commentary”) to the new regulations makes this very observation and notes how unfair that standard is.

Now the VA has borrowed the federally-mandated Medicaid Community Spouse Resource Allowance (CSRA) as a net worth limit. The CSRA is an amount set by the Centers for Medicare and Medicaid Services on an annual basis and is used to determine the level of countable assets the spouse of a nursing home resident is allowed to retain while qualifying the nursing home resident for Medicaid. This year (2018) that amount is $123,600.

Under Reg. § 3.274(a)-(b) we now have a bright-line net worth test equal to the CSRA ($123,600 . . . it will go up in 2019). Though the CMS Medicaid number is obviously intended for use by a married couple (one spouse in the community, the other in the nursing home), in the VA context it applies to every applicant, regardless of marital status.

Example: Harry is married to Mildred. They have $100,000 in VA countable assets. Under the old/existing scheme Harry would not qualify for VA benefits. Under the new scheme he will (with room to spare).

Example: Harry died. Mildred needs to apply for VA benefits. Under the new rules, no problem. As long as she is under $123,600.

I’ll have some more specific comments about trusts and annuities, and how they relate to net worth, below.

The Dark Side: Residential Real Property

Under the old rules, a residence and underlying/surrounding land “similar in size to other residential lots in the vicinity” were not countable. If every residence in the area was on a 50 acre farm, the applicant’s residence and surrounding farm land would not be countable.

The new rules impose a 2 acre limit “unless the additional acreage is not marketable.” The examples given with regard to nonmarketable acreage related to acreage “only slightly more than 2 acres,” property that might be inaccessible (surrounded by other owners, perhaps) or property subject to zoning limits that could prevent a sale.

Example: Under the old rules Dad living on 10 acres of land, which seems to be the semi-rural standard in his neighborhood. Under the new rules, Dad likely has eight acres of countable real estate.

Transfer Penalties

Under old VA rules, there has been NO transfer penalty. This means that Mom or Dad could transfer excess assets and apply for VA benefits the next day. New Reg. § 2.276(e) now imposes transfer penalties.

The Commentary and the regulations clearly say that the new transfer rules apply to transfer made AFTER the rules become effective. You have until October 18, 2018 to transfer excess assets without being subject to the new rules.

Effective October 19, 2018, transfers of “covered assets” transferred after October 18, 2018, will be reviewed for a period of thirty-six (36) months to determine whether a transfer penalty (a period of ineligibility for VA benefits) should be applied.

Below, I will review what transfers will be sanctioned (not all transfers will be) and how the penalty will be calculated

Applies to “Excess Asset” Transfers Only

The term used by the VA is “covered assets.” A transfer penalty applies to those amounts transferred that exceeded the net worth limitation and only to the extent that, if retained, would have caused the applicant to exceed the limitation. See Reg. § 3.276(a)(3).

Example: Edith transferred $20,000 to her daughter on October 20, 2018, and applied for VA benefits on November 1, 2018, with $70,000 cash in her checking account. There will be NO VA transfer sanction because Edith was below the net worth limit before the transfer and the transfer did not cause her to dip below the limit (she was already below it!).

Example: Joe transferred $50,000 to his son on October 20, 2018. He applied for VA benefits on November 1, 2018. At the time of the application he had $100,000 cash. Accordingly, at the time of the transfer Joe had $150,000. The net worth limit is $123,600. His net worth at the time of the transfer exceeded the net worth limit by $26,400 ($150,000 – $123,600). As a result of the transfer, $26,400 will be subject to a penalty (which will be calculated below).

Calculating the Transfer Penalty

Once the covered asset amount (the amount subject to the transfer sanction) has been determined, the penalty or sanction can be determined.

Divide the value of the covered assets by a divisor that will always be the “Maximum Annual Pension Rate” (MAPR) for a veteran with one dependent. The MAPR for a veteran qualifying for Aid & Attendance benefit (the highest) with one dependent is $26,036 annually. The regulations say to divide that by 12 and drop the cents. Reg. § 3.276(e)(1). In 2018 that amount is $2,169 ($26,036/12 = $2,169.67).

It does not matter at whether the transfer penalty is being calculated for a single veteran, a married veteran, or a widow of a veteran. Always use the MAPR for a veteran with a dependent divided by 12.

Example: Joe, from above, had a covered amount of $26,400. His sanction is 12.17 months.

When the Penalty Begins to Run and When It Ends

The penalty begins to run on the first day of the month following the month of transfer. Reg. § 3.276(e)(2). The sanction ends on the last day of the month in which the sanction expires and the applicant is again eligible for benefits on the first day of the following month. Reg. § 3.276(e)(3).

Example: Back to Joe. Joe transferred $50,000 on October 20, 2018. We determined that $26,400 was the covered amount, and that generated a sanction of 12.17 months beginning November 1, 2018. The 12.17 month sanction period expired sometime during November, 2019, and Joe would be eligible for benefits beginning December 1, 2019.

Can a Transfer Be Cured?

Yes. A transfer can be corrected, wholly or partially, if the correction is made within certain time periods (involving notice from the VA and notice back to the VA that corrective action has been taken). I am not going to dwell on that topic in this article. Since we have enough to deal with now, we’ll come back to it.

Trusts and Annuities

The new rules add some unwelcome clarity to the use of trusts and annuities.

A bit of history: I have explained to my students and clients for years that under Medicaid and SSI the asset transfer rules apply only to assets that, although once owned by the applicant or a spouse, are no longer countable or available assets. Conversely, if the asset is deemed to be available or countable, the transfer rules are inapplicable. This may seem simple, but it is easy to mix the two types of rules up.

Remember: If the transfer rules apply, it is because the asset is no longer deemed available. Now to the new VA regulations.

Reg. § 3.276(a)(5)(ii) clearly says that a transfer that reduces net worth is a sanctionable transfer UNLESS the applicant can liquidate the entire balance transferred for his or her own use. The Commentary discusses at length that it is irrelevant that the transferred asset produces income. The transfer rules will sanction the transfer of the principal asset and the income rules will result in payments back to the applicant as countable income.

Annuities

This, of course, is what occurs upon the purchase of an annuity. The single premium is paid to the insurance company, and an annuity stream comes back to the annuitant. The regulations and the Commentary explicitly apply this concept to annuities.

If an annuity is purchased, yet the applicant can liquidate the annuity, then the asset is countable. If an annuity is purchased and the applicant is no longer able to liquidate the asset for his or her own use, it is a transfer (though it will throw off countable income to the applicant).

In my opinion, this will all but kill the use of annuities in short-term/crisis VA benefit planning. In fact, the commentary devotes considerable space to a discussion that this was the very intent given the government’s perception that veterans were being abused by annuity sales schemes.

Trusts

There has been considerable confusion over the years about the VA treatment of trusts, particularly irrevocable grantor-type trusts in which the grantor has retained an income interest. The question was, did the retention of an income stream constitute enough of a “use for the benefit of the applicant” so as to render the entire trust countable for VA benefit purposes?

The regulations have provided an answer.

Reg. § 3.276(a)(5)(ii) specifically applies to both trusts and annuities. All of the commentary directed to annuities applies to trusts.

If an applicant transfers assets to a trustee and surrenders all of his or her right to liquidate the trust for his or her own benefit, yet retains an income interest, the result is no different than the purchase of an annuity.

If an asset transfer to trust is sanctionable (as it clearly is under the regulations if the applicant has retained no right to liquidate or control the trust for his or her own benefit) the transferred assets cannot be deemed available.

Of course, I believe that nongrantor, irrevocable trusts are clearly not countable (and never were). On the other hand, I believe it is now clear that irrevocable “income only” trusts are also not countable (although any income distributed to the applicant clearly is countable income).

Alas, while the trusts are not countable, funding them is now a potentially sanctionable event (depending on whether the assets transferred to trust are considered “covered assets” – discussed above – and whether the funding event occurred within 36 months of the application or whether the sanction may have run its course during the preceding 36 month look back period).

Trusts can still be a useful tool. But the potential applicant (or applicant family) needs to have the foresight to start early with planning.

Going Forward

In the meantime, if you or any of your clients have been meaning to “git ‘round to it” on planning you have just a few weeks left. Get on it! Now!

A Grantor Trust, Or Not? Answers.

I also challenged you to analyze the facts to determine whether you believed the trust in question to be a grantor trust or a non-grantor trust. I then promised you I’d be back in a few days to let you know if the IRS agrees.

So, here goes . . .

If you determined the trust was a non-grantor trust, consider yourself a Trust Einstein. It is NOT a grantor trust.

But I have a confession to make: I was wrong at first. I’ll explain why below.

The Service recently issued a letter ruling on our facts determining that the trust was NOT a grantor trust. You can look at Private Letter Ruling 201650005 and see for yourself. As with many letter rulings, however, it is somewhat conclusory.

Let me fill in a bit.

Most of the ruling hinges on the status of the various parties other than the grantor, and how much power the Distribution Committee had. One aspect also related to the manner in which the trust agreement circumscribed the grantor’s power to unilaterally act.

Extreme succinctness notwithstanding, the ruling provides a good, brief review of the grantor trust rules and it tracks some of the analysis we use in Module Three at BaseCamp.

Adverse and Nonadverse Parties

First determine who the adverse parties are. All of the members of the Distribution Committee (other than grantor, of course) are adverse parties. In fact, in two of the three potential distribution scenarios, the grantor is completely at the mercy of (or, I guess, on the side with) a majority of Distribution Committee; He can’t act alone (except in distribution scenario three discussed below).

Grantor Trust Powers Analyzed

As we teach at BaseCamp, when analyzing a grantor/non-grantor trust scenario, first determine whether there is a power or right that potentially involves a grantor trust power or right defined in IRC §§ 673-678. If there is, then determine whether it is relevant that an adverse party could block, thwart or hinder the exercise of that power or right.

Section 673

I’ll address IRC § 673 last because, frankly, it stumped me for a bit. We’ll come back to that.

Section 674

Section 674(a) lays out the general rule that a grantor will be treated as a trust owner if she or a nonadverse party can affect the beneficial enjoyment of the trust (or a portion thereof) without the approval of an adverse party. That’s why I call adverse parties party wreckers.

Obviously, under Distribution Scenarios One and Two Gerald Grantor can’t do much of anything without a majority of the Distribution Committee (all adverse) cooperating.

Subsection (b)(3)

Income and principal were potentially “accumulatable” (my term) and, accordingly appointable by Grantor’s will. If income (including capital gains) can be accumulated within the discretion of either grantor or a nonadverse party for later appointment by grantor’s will, IRC § 673(b)(3) will “trigger” grantor trust status, UNLESS the decision to accumulate or not cannot be taken without the consent of an adverse party. That is the case in our fact pattern. So much for subsection (b)(3).

Subsection (b)(5)

The only other IRC § 674 power implicated is IRC § 674(b)(5)(A). READ THIS BECAUSE THIS IS IMPORTANT. It is important because many folks overlook this (as either a trap or an opportunity).

IRC § 674(b)(5)(A) is an exception to IRC § 674(a): Fit within the exception and the power does not constitute a grantor trust. Section 674(b)(5)(A) refers to is a power to distribute corpus to a beneficiary regardless of by whom the power is held (yes, folks, even the grantor) as long as the power is circumscribed by a reasonably definite standard.

Distribution Scenario Three gives Gerald Grantor the authority to direct distributions of principal to any beneficiary other than himself for the “health, maintenance, and support” of the beneficiary. HEMS is a “reasonably definite standard” (actually that standard is a bit broader than the familiar HEMS).

That takes care of IRC § 674. What about IRC § 675?

Section 675

IRC § 675 involves a variety of powers pertaining to administration of the trust. Broadly, all Section 675 powers fall into two categories. In one category if the powers are subject to the cooperation of adverse parties the powers involved will not trigger grantor trust status. In the other category of rules grantor trust status depends entirely upon whether the power was actually triggered and thus depend entirely upon facts and circumstances of trust administration on a tax year-to-tax year basis. The letter ruling specifically says that much of IRC § 675 is “attendant on the operation of the Trust” and any decision would need to be “deferred until” further examination of federal returns.

Sections 676 and 677

Sections 676 (power to revoke) and 677 (income for the benefit of grantor or spouse) are entirely dependent on no adverse party involvement. If an adverse party must consent or cooperate, it is not a grantor trust. Moving right along . . . .

Section 678

I’ve always thought IRC § 678 to be interesting. Read Use IRC Section 678 to Make a Trustee Very Angry. Section 678 is the only section under which someone other than the grantor can be deemed trust owner if she has sole discretion to make a distribution to a class that includes herself. First, the trust must not be a grantor trust with respect to the grantor, and second, the power holder’s discretion must sole. No person in our fact pattern has that authority.

Bob’s Section 673 True Confession

True Confessions Time. I went along with everything described above. I choked on IRC § 673.

Section 673 says that the trust will be a grantor trust if the grantor retains a potential reversionary right that exceeds 5% of the trust value. In determining the value of the potential reversionary interest IRC 673(c) tells us to assume “the maximum exercise of discretion in favor of grantor.”

There. The reversionary interest is worth 100% because under Distribution Scenarios One and Two distributions could be made to Gerald Grantor and if we assumed the Distribution Committee exercises maximum discretion . . . . WRONG!

Two practice pointers:

One, assume the IRS prints nothing irrelevant in the fact pattern of a letter ruling. If it is in there, it is relevant.

Two, RAFTA! RAFTA! RAFTA! (Read All the Friggin’ Trust Agreement).

The fact pattern in the letter ruling says that Article One, Section 3 of the Trust Agreement says, “Grantor’s intentions in creating Trust are, generally, that Trust is a non-grantor trust . . . . [and] that all provisions to this agreement shall be interpreted in such a manner so as to give effect to these intentions. Any power that is contrary to these intentions shall be void.”

In other words, the Service gave effect to self-serving “boilerplate” that we often see. In our case, the power to distribute to grantor under section 673 could not be interpreted to exceed more than 5% of the value of the trust.

Nongrantor Trust But Estate Inclusion

I didn’t analyze why the Service concluded the entire trust would be includible in Gerald Grantor’s estate. But it would be due to any number of reasons Under IRC §§ 2036 and 2038. In any event, the result of that would have been stepped-up basis in the assets on the death of Gerald.

In the elder law context we can think of reasons we’d want a nongrantor trust that insured basis step-up, could we not? Of course we could!

Give this little gem a whirl! Test yourself.

I always (well . . . often) like a challenge. Try this one on for size from a recent letter ruling. Someone was willing to pay the IRS a $28,300 user fee for this little gem. And that doesn’t count attorney fees and expenses.

In any event, the facts are a great way for you to test yourself. If you are a BaseCamp subscriber and have gotten through Module Two, see how much stuck, because we covered all of this. If you are not a BaseCamper, but feel you ‘know your stuff’ then wrap your head around this.

Facts

Gerald Grantor established an irrevocable trust. The identity of the trustee is irrelevant (and was not discussed in the ruling). The beneficiaries are Gerald, Gerald’s spouse Wilma, Gerald’s mother Mom, and Gerald’s two children Camilla and Charles.

Gerald’s stated intent in the trust agreement is to insure the trust is included in his estate but to AVOID grantor trust status. (By the way, in the elder law context it isn’t topo unusual to want to avoid grantor trust status yet insure basis step-up through estate inclusion.)

Gerald has also retained a testamentary general power of appointment.

The trust agreement also identifies a Distribution Committee consisting of Gerald, Mom, Camilla, and Charles.

Distributions of principal and income may be made to any beneficiary under the following circumstances:

As directed by a majority of the Distribution Committee with Gerald’s consent.

As directed by all Distribution Committee members other than Gerald.

As directed by Gerald (in a nonfiduciary capacity) to a beneficiary other than himself and for the health, education, maintenance, and support of that beneficiary.

So here’s the $28,300 question: Is this trust a grantor trust or not?

If you’re brave, sort through this and come up with an answer. BaseCampers: Cheating is allowed, go look at Module Two.

What IS cheating is to go find the letter ruling. I’ll get back to you in a few days with an answer and some discussion.

Squeezing Capital Gains Taxation from Trusts to Beneficiaries

Adam and Hoss Cartwright, cotrustees of the Ben Cartwright Irrevocable Trust established by their father 10 years ago, want to sell Ponderosa, a trust asset, for

$500,000. The CPA told them that the sale of Ponderosa will generate a $250,000 capital gain taxed at 23.8%. The CPA also told them that if Ponderosa was not “trapped in that trust” the sale would have been taxed at 15% (or even lower) in their (and Little Joe’s) hands.

They want to know if you have any ideas. Because you’ve read this article, you do.

The Tax Problem

The capital gains tax rate for any person or trust in the 39.6% tax bracket is 20% (as opposed to 15% or less for those in lower brackets). If the gain is investment income (capital gains invariably are for trusts) a surtax of 3.8% applies to trusts in the 39.6% bracket.[1] The difference between a trust and an individual is that a trust reaches the 39.6% bracket at taxable income of just $12,500 compared with an individual at taxable income of $416,700.

The Trusts/Capital Gains Tax Trap

The sale of a trust asset represents a mere conversion of a portion of trust principal from a tangible asset into fungible cash. The proceeds remain allocated to principal. To do otherwise would slight the mythical remainder beneficiary anticipating the benefits of an eventual distribution of trust principal.

Both state laws governing the allocations of principal and income and federal tax law track this notion. Capital gains are part of principal and should stay in the trust. Income distributed to the beneficiaries is taxed to the beneficiaries.

The tax concept of distributable net income (DNI) applies to determine what items of trust income, deduction, and credit should be deemed to be distributable to the income beneficiaries, and what of those items should be deemed to remain in trust (presumably to impact distributions to remainder beneficiaries). Taxable amounts of DNI distributed to beneficiaries are taxed to the beneficiaries; taxable amounts of DNI not distributed to beneficiaries, as well as taxable income not included in DNI, are taxed to the trust.

Tax and state law generally allocate capital gains to principal and exclude it from DNI. There are, however, a number of regulatory exceptions.

A provision of the 2004 tax regulations[2] provides exceptions to allow for the inclusion of capital gains in DNI (hereinafter the “Regulation”). A thorough discussion of the entire (and dense) Regulation is beyond the scope of this article.[3] My intent is to “point you in the right direction” in the event you advise a client like the Cartwrights.

In any event, the goal with the Cartwright Trust is to attempt to avoid capital gains taxation at the trust level by having capital gains included in DNI. Obviously, with an old trust document like the Cartwright Trust, which may have been drafted with very little tax planning, your options might be limited. Nevertheless, let’s take a look.

A Necessary Power

Does the trust document grant trustee authority to make discretionary distributions of principal?

Fortunately, the Cartwright Trust grants the cotrustees authority to make discretionary distributions of principal among Ben’s descendants in shares of their choosing. If Adam and Hoss did not have that discretionary authority, your inquiry would end.

Because Adam and Hoss have the authority to make discretionary distributions of principal, we can review a few strategies.

Strategy No. 1

Consider simply distributing Ponderosa to one or more beneficiaries (in either equal or disproportionate shares). If Ponderosa is distributed in-kind, the beneficiaries will take a transferred basis.[4] Upon a subsequent sale by the beneficiaries, they will recognize the gain.[5]

Obviously, the cotrustees must have the authority under either the trust document or state law to distribute in-kind.

Look for it first in the document. If it is not there, look for it under your state’s version of the principal and income act. Also, do not forget to check the fiduciary powers incorporated by reference statute.

Like many states, the North Carolina General Statutes provide a laundry list of fiduciary powers that may be incorporated by mere reference. Buried in the North Carolina list is the authority “[t]o make distribution of capital assets of the estate or trust in kind or in cash, or partially in kind and partially in cash . . . .”[6]

Also, check your state’s trust code. For example, Uniform Trust Code (UTC) section 816(22) is not helpful, but the North Carolina version grants a trustee specific power “to distribute trust property in kind or in cash, or partially in kind and partially in cash, in divided or undivided interests.”[7]

Strategy No. 2

Rather than distributing the asset, the Regulation provides that if capital gains are “utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary,” then capital gains can be included in DNI.[8]

Examples 5 and 6 of the Regulation illustrate different facets of the point. In Example 5 trustee elects, pursuant to trust agreement discretionary authority, to distribute principal “only to the extent” of capital gains (i.e. trustee “utilizes” capital gains to determine the distribution amount). This could apply to the Cartwright Trust, if the cotrustees elect to distribute the capital gain on the sale ($250,000).

In Example 6, the trust agreement mandated the sale of Blackacre and a distribution of the proceeds. Because trustee was forced to “utilize” capital gains to determine a required distribution, capital gains could be included in DNI.[9] The Cartwright Trust contains no such mandated distribution; all principal distributions are discretionary.

Further, the Regulation offers no example in which the trustee uses discretionary authority to distribute the entire proceeds of sale and include capital gains in DNI. On the other hand, the examples are safe harbors, and the Service acknowledged in the preamble to the Regulation that it could not illustrate every conceivable situation.

The “utilizes” prong refers to amounts “distributed or required to be distributed.”[10] The Example illustrates a “required to be distributed” situation, but Regulation subsection (b)(3) supports the discretionary distribution.[11] Accordingly, the Cartwright Trustee could distribute the entire $500,000 sale proceeds and include capital gain in DNI.

Strategy No. 3

It may be possible to allocate capital gains to discretionary distributions of trust principal. The Regulation says that a trustee acting in a reasonable and impartial manner in accordance with either state law or a trust provision may include capital gain otherwise allocated to principal as part of DNI as long as the trustee includes the capital gain in DNI consistently over the years.[12] A key word is “consistently.”

Regulation Examples 1 and 2 illustrate the consistency requirement. In both examples, a trustee has authority to deem discretionary distributions of principal to be made first from capital gains. In Example 1, during the first year of the trust trustee makes a discretionary distribution of principal but fails to exercise the deeming power. In Example 2 the trustee deems the distribution of principal to have come first from capital gains.[13] In both cases, the trustee was locked in. Pick your poison.

Check the trust’s back Forms 1041. Perhaps the Cartwright Trust never had capital gains. Funding a trust with real property and never realizing any capital gains is not unusual.

If that is the case with the Cartwright Trust, there was never a consistent practice established. If the cotrustees are willing to commit to deeming any future principal distributions to be from capital gains, and if they are duly authorized, then they could distribute the gain from Ponderosa’s sale and include it in DNI.

Specific trust agreement authority to include capital gains in DNI is the basis of both Regulation examples. What if the Cartwright Trust grants no such authority?

Would it be possible to rely on discretion granted by state law? A plain reading of the Regulation seems to allow this.[14]

Again, the UTC is not helpful, but a number of states added language to their versions of the UTC to provide the discretionary power. North Carolina and Alaska are examples.[15] If your state does not and the power is critical to a client, you could consider moving trust situs to one of these states.[16]

A Lesson for Future Trusts

These strategies are designed to provide tax-optimizing planning strategies when the trust and federal and state law allow. But even if you are not able to utilize them to help the Cartwrights, you have learned a valuable lesson about a number of powers to include in your future trusts.

[1] The surtax applies to individuals with modified adjusted gross income over $200,000.

[3] For a thorough discussion and analysis, see Jonathan G. Blattmachr & Mitchell M. Gans, The Final ‘Income’ Regulations: Their Meaning and Importance, 103 Tax Notes 891 (2004), and John Goldsbury, Dealing with the 23.8% Tax on Trust Capital Gains (2014) at http://bit.ly/2eVUnyR.

I don’t know why everyone is so exercised about this tax on cats, especially in the context of an elder law or special needs law practice. I can see where it might apply to a pet trust, but not your typical nongrantor trust.

A participant in the recent TrustChimp Summit in Greensboro asked me about that tax. Then I realized my dear spouse has been urging me to have my hearing checked. The participant was asking about the KIDDIE TAX. Oh, yes, hahaha. Me funny.

He wanted to know how the Kiddie Tax applied to trust distributions (I believe we were talking about third party special needs trusts that were being taxed as nongrantor trusts). We were down to the last 30 minutes or so of a three day seminar and we were a bit behind . . . and I gave a less than stellar answer.

So here goes . . . .

Kiddie Tax Background

The so-called “Kiddie Tax” taxes the unearned income of a minor (and certain other dependents) at the parents’ highest marginal tax rate. As we’ll see, there is a HUGE exception in the context of most of our practices.

The so-called “Kiddie tax” taxes minors (and other younger adult dependents – notably college students under 24 relying on Mommy’s and Daddy’s largesse) at the parents’ highest marginal tax rate on UNEARNED income over $2,100. IRC § 1(g)(1). If the child is over 19 and under 24 and is earning more than half of what his or her support needs are, the Kiddie Tax will not apply (alas, my college freshman son is not thus exempted).

The first $1,050 of the child’s unearned income is not taxed. The next $1,050 is taxed at the child’s tax rate. The parents’ highest marginal tax rate kicks in over $2,100.

Example: Don Draper set up an investment account for the benefit of his daughter Sally Draper at a Madison Avenue advisory firm (Jonathan Blattmachr’s firm Pioneer Wealth Partners . . . it IS on Madison Avenue . . . REALLY . . . not making that up). During the year the investment account pays Sally $5,000 in interest and dividends. She has earned income of $3,500. The first $1,050 of unearned income is not taxed, the next $1,050 unearned income is taxed at Sally’s rate, as is her $3,500 earned income. The $2,900 excess unearned income is taxed to Sally at Don’s marginal rate of 39.6% (given his seven figure payout from Sterling/Cooper Advertising Agency). Alternatively, Don could report Sally’s unearned income subject to the Kiddie Tax on his return.

As alumni of the TrustChimp Trust Summits well know, distributions of income from nongrantor trusts to a beneficiary generally retain their character in the hands of the beneficiary. Under the distributable net income (DNI) rules of IRC § 634, the beneficiary will report these distributions on her tax return. If the beneficiary is a minor (or other young person covered by the Kiddie Tax) distributions of unearned income that are carried out of the trust by DNI are subject to the Kiddie Tax rules.

BIG Exception For Qualified Disability Trusts

Distributions from a “qualified Disability Trust” (QDT) are not considered unearned income subject to the Kiddie Tax rules. IRC § 4(g)(4)(C).

A Qualified Disability Trust “is a disability trust described in subsection (c)(2)(B)(iv) of section 1917 of the Social Security Act [42 U.S.C. § 1396p(c)(2)(B)(iv)] . . . and all of the beneficiaries of the trust as of the close of the taxable year are determined by the Commissioner of Social Security to have been disabled . . . for some portion of the year.” IRC § 642(b)(2)(C)(ii).

A “(B)(iv)” trust refers to a trust “solely for the benefit of” a disabled individual under age 65. This raises a number of interesting issues:

My narrow reading of the statute is that 42 USC § 1396p(c)(2)(B)(iv) describes just two types of trusts: D4A Trusts and Sole Benefit Trusts. Such trusts have a number of requirements, chief among them being “solely for the benefit of” a single individual. Nevertheless, the tax statute refers to “all of the beneficiaries.” Strange, no?

A number of commentators (and, in practice, apparently the IRS) take a broader view that as long as “all” of the beneficiaries have been determined to be disabled, the exemption is available to any third party trust that benefits solely disabled beneficiaries during the applicable tax year.[1]

The trust may not be a grantor trust. Essentially a grantor trust is treated as the alter ego for income tax purposes of the grantor who funded the trust. As many of you know (and as all Trust Summit alumni know), a D4A Trust that has been funded by the beneficiary is always a grantor trust. If my narrow reading of IRC § 642 is correct, QDT treatment would be available to “sole benefit trusts” only, which gives credence to the more liberal interpretation of the statute because it seems improbable that Congress would wish to tailor such an incredibly narrow benefit for disabled individuals.

Incidentally, QDTs are entitled to the much larger personal exemption available to an individual ($4,050) as opposed to the $100 or $300 exemption usual available to trusts. IRC § 642(b)(2)(C). In fact that seems to be the thrust of the QDT statute. More on that elsewhere.

But the juiciest item for the special needs law attorney is that if a third party special needs trusts is, in fact, considered a QDT distributions to the beneficiary are not deemed unearned income. Accordingly, the distributions are taxed at the beneficiary’s rates and not subject to the Kiddie Tax.

Example: Back to Don Draper and Sally’s investment account. Because Sally has developed some sort of severe disability Don set-ups the investment account under a third party special needs trust and names his partner Roger Sterling as trustee. ALL distributions subject to taxation will be taxed at Sally’s (no doubt) very low tax rate. That’s because the otherwise unearned income will be treated as “earned income” for purposes of the Kiddie Tax rules.

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[1]See, e.g., Landsman and Fleming, What is a “qualified disability trust” for Federal income tax purposes?, Special Needs Alliance (undated) (available online at www.specialneedsalliance.org/taxes.pdf).

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